Information Was Meant To Be Expensive

Felix Salmon has a good run down of all the various things that went wrong with the Facebook IPO. I don’t really care about most of this – who cares if Facebook mis-priced the deal? Who cares if they pissed off investors? This is stuff that matters only to people who are actively playing the game.

What matters to the rest of us is the insider-trading angle.

From what I’ve read, that angle is: Facebook gave late, updated revenue estimates to Morgan Stanley; Morgan Stanley passed these on to select investors as part of their analysis, but not to the general public; therefore, disfavored (retail or small institutional investors) who didn’t get the call were stuck with shares that the smart money knew to avoid. All of this is alleged, not proved – I’m not even sure lawsuits have been filed – but that’s the gist of it.

The two extreme views about insider trading look roughly like this. On the one end are the Chicago types who argue that insider trading is good, because what makes capital markets most efficient is the swiftest dissemination of information. Regardless of where the information comes from, you want it out as swiftly as possible, so prices can incorporate it. That means putting no obstacles to disseminating that information – which means no laws against insider trading.

The opposite view points out, quite correctly, that efficiency in information distribution is not the only thing that makes markets work well. You also want depth. Depth requires a certain level of trust. That, in turn, requires believing that you are not constantly being screwed by people with inside information. Plus there’s this small basic fairness issue – it really does feel like a species of fraud and corruption to let insiders profit from their position. So this extreme argues that the solution is to mandate the wide dissemination of any information that is disseminated at all. If you know something that most people don’t, you can’t trade on it – unless you first tell everybody.

The problem with this second viewpoint is that, taken to its logical extreme, it forbids proprietary research of any kind. After all, the product of that research either is useful (in terms of identifying profitable market-trading opportunities) or it isn’t. And if it is, then it’s information. Which you have. And other people don’t. The whole controversy over high-frequency trading revolves around this kind of information – information gleaned from analyzing trading patterns which fast computers can take advantage of before ordinary market participants can reach for their computer. In the real world, most of these patterns are patterns of behavior exhibited by other traders, like large mutual funds. In other words, high-frequency traders are trading ahead of retail order flow, and profiting at those retail investors’ expense. If there’s no difference in effect between trading on a tip from the mutual fund and trading based on having watched that fund’s behavior for months, then why is one evil insider trading and the other legitimate research?

Research is a Wall Street product. Back in the days of the dot-com bust, the charge was that this product was worthless – designed to sell shares, not provide a true picture of the health of companies or the likely prospects of making money by investing. The charge in the Facebook case is that the research is valuable – and therefore should have been made generally available, not only to select clients. The logical end-point of this kind of reasoning is that the Wall Street houses shouldn’t provide research – they should just offer product and let the clients decide what they want to buy, without “selling” it on the merits. Except this is exactly what the major Wall Street houses did with the mortgage-backed CDOs and other structured products that destroyed the world economy. And they have been criticized for that as well.

All of this rumination is not intended to serve as a defense of Wall Street’s practices. It’s intended to argue that trying to insure that information disseminated by Wall Street is both accurate and generally available is a fool’s errand. Accurate information is valuable, and therefore expensive. You can police the margins – and those margins may well have been crossed in this case – but the problem in intrinsic to the fact that information asymmetries arise naturally all the time, and information asymmetries are the main way people make money.

Ultimately, the way to make Wall Street work better for everybody is probably just to tax it more heavily.

I guess I’d appreciate this argument better if Morgan Stanley had come upon this information by actual “proprietary research,” as opposed to “they gave us a phone call.”

Proprietary research is when the firm calls suppliers and wholesalers, secret shoppers and ad companies, does surveys and audits, and puts it all together. Proprietary research is not “I know this guy and he told me.” That’s information rentierism.